Surprise! We're in the midst of an oil shock and its impact could be as nasty as the first three, writes David Potts.

Here's hoping it will be fourth time lucky, but the past three oil shocks resulted in recessions.

The fourth oil drama has crept up on us, which perhaps explains why it isn't being taken as seriously as the others. Come to think of it, they weren't taken as seriously as they should have been at the time either, although it must be said the third oil shock - the price spike in Gulf War part one - quickly gave way to the biggest bull run ever in the sharemarket.

Still, there's no doubt that a creeping seems less alarming than a big-bang crisis when, in truth, it is just as much an economic shock even if the impact is less obvious and more likely to be drawn out.

Don't forget that on the eve of the Gulf War part two, the Iraq invasion, analysts were saying high oil prices were temporary. BRW magazine reported at the time that "some oil analysts believe expectations of a price as low as $US20 a barrel are optimistic. Something about $US25 is more likely." The general feeling was that after six months the price of oil wouldn't be a problem.

Although a record, that's nothing compared with the 1990 shock, which in today's prices would be more like $US60 a barrel. The original oil shock of the '70s would be more like $US100 a barrel. No wonder it plunged the world into a recession and pushed up inflation.

And, yes, oil has been a bit accident prone of late. There have been any number of one-off incidents, beginning with the Iraq invasion and moving on to a cold winter in the US, through a strike in Venezuela, which is the fifth biggest producer, then a six-day strike in Nigeria, on to the collapse of the Russian oil giant Yukos and finishing up, as we speak, with the threat of a terrorist attack on Texan refineries.

With the exception of the US winter, which has now given way to a US summer where everybody goes on holiday and drives, these have all been problems on the supply side of oil. Certainly enough to make the markets jittery.

A CRUDE AFFAIR
The trouble is, that's only half the story.

For a start there's a more pressing supply side problem - not enough oil discoveries, and a lack of refining capacity to cope with what has been discovered.

But the real problem, if you can call it that, is on the demand side. The economic boom in oil-guzzling China, plus strong demand in the US and South-East Asia are out- stripping capacity. This might not seem to be too bad a problem to have, especially when you consider the alternatives, but it's not sustainable.

No wonder few analysts see $US40-plus prices as only temporary. If anything, $US40 has become the bottom of the range price, with $US50 just around the corner.

To give you an idea of the strength of this demand, a recent Chinese Government report forecasts oil imports into China, the world's second biggest importer of energy after the US, will be between 20 and 30 per cent higher than last year, itself a 31 per cent increase on the year before.

And that's not even mentioning India, another booming and energy hungry economy.

But wait, there's worse.

It's been estimated that Saudi Arabia, by far the biggest producer, will need to almost double its production of crude to keep up with demand over the next decade.

Yet its officials predict it will be producing only 10.2 million barrels a day in 2011, not much more than what it produces now.

With the Iraqi oil wells in a mess, and terrorists believed to be targeting Saudi fields and refineries in Texas, there's even a distinct possibility that production will fall as demand is rising. That would produce the mother of all oil squeezes.

Meanwhile hedge funds and other speculators, plus buyers building up stocks, will almost certainly be making the shortage worse well in advance.

THE ECONOMY
It's the fact that strong demand, rather than a supply disruption, is responsible for rising oil prices that makes the fourth oil shock different.

The Australian economy is bubbling along and apart from petrol prices rising above $1 a litre - the rule of thumb is that every $US1 rise in the price of oil means a one-cent-a-litre rise at the petrol pump - you would not know there's a crisis in the making.

Inflation is still tame except in the building industry, but then that has nothing to do with oil and everything to do with overheating caused by still low interest rates.

There's no threat to jobs, high oil prices are good for other commodity prices and while Australia has a debt problem, that's nothing new.

INTEREST RATES
It's when you look at the rest of the world, especially the US, that you have to start worrying. And sooner or later the problem will catch up with us.

Oil prices are rising at the same time as interest rates. In the case of the US, it's also as the impact of the Bush Administration's tax cuts starts to fade.

An oil price rise is like a tax or interest-rate increase. In this case, US consumers are getting a double dose.

As it is, there are already grave fears that the US recovery will peter out, which is why US interest rates remain ridiculously low. The partners in crime of rising interest rates and oil prices have always caused recessions in the US.

This time at least, economists think the impact is more likely to be on inflation.

Either way, it will give the US Federal Reserve second thoughts about increasing interest rates, at least before the November elections, and probably for a while after. Its official line, by the way, is that the oil price rise is "transitory".

The US recovery missed a beat in the June quarter and while it appears to have picked up momentum again, it's not as strong as economists had been predicting a year ago.

Little wonder, considering oil prices are more than 40 per cent higher.

Our Reserve Bank also has its hands tied because the election isn't far off.

Even so, Australia came out the worse for wear after the past three oil shocks with a higher inflation rate than our trading partners' and so the Reserve will have to move eventually.

THE DOLLAR
Oil and gold prices usually move together, along with other commodities. At the same time the US dollar drops. Both are good for our dollar.

So all things considered, it should be back at 80 US cents. So why isn't it?

Maybe it's just a matter of time since the markets still seem to be in denial about a fourth oil shock.

Or maybe there's something else. Such as a flight to safety, when no matter what happens in the US, speculators would prefer to be holding US dollars than any other currency.

Once it becomes obvious that oil prices aren't going to fall, and as a result the Federal Reserve won't be able to lift interest rates, the markets will go into overdrive.

Then the dollar could do anything. And probably will.

OIL SHARES
At least the picture is clearer for investors. Buy black gold.

Or should you? Resource stocks have already had a great run, so you won't be buying them at exactly bargain-basement prices. And the dollar could swing either way.

Mind you, the respected tipsheet Fat Prophets has no doubts, since it's forecasting oil prices will go above $US50 a barrel. "Over the coming 12 months, we also believe that growing investor recognition of the bull market in oil will be the catalyst for out performance in energy stocks," it said, singling out Oil Search and Woodside.

Oil Search is a PNG producer with the bonus of being involved in the gas line project. It has strong cash flows and is debt free, Fat Prophets said.

Brokers say it's hard to go past the blue chip BHP Billiton, which boasts a very profitable petroleum division. And also pays a dividend. But, alas, it isn't cheap.

Still that's a good sign.

"With BHP Billiton at an all-time high and mid-sized oil cap stocks following, that's a sign of broad strength that this will continue," said Phillip Shamieh, general manager of tipsheet Investment Wise.

Popular oil stocks with brokers are Australian Worldwide Exploration, Hardman Resources, Roc Oil, Santos, Tap Oil and Woodside. But all are trading at or near records, and any increase from now is hardly likely to be spectacular.

Funnily enough, the smaller oil stocks aren't such a good play on the price of oil. What they find is more important.

You also have to bear in mind what the overall market, especially Wall Street, is doing.

A serious correction would almost certainly drag oil stocks down with it, though not as far.

OTHER STOCKS
Mind you, the best investments in an oil shock may not be in oil stocks at all since they've become pricey, although that doesn't rule out more increases.

"People tend to think the whole resources sector will rise. But you need to be picky," said Shamieh.

He suggests that explorers that are just turning into producers offer the best prospects. Stocks such as Nexus Energy and Voyager Energy.

The price of gold tends to rise along with oil, so there's room for a catch-up there too.

Brokers like Newmont Mining, the world's biggest goldmining company. It doesn't forward sell its gold - a bizarre practice of other producers, which for years depressed the price of bullion since the whole point of doing it was because they weren't confident about future prices - so any increase goes straight into profits.

But be careful because an increase in the price of gold pre-supposes a drop in the value of the US dollar - and so a rise in our dollar.

Patersons Securities recommends Alinta, which comes with a 6 per cent fully franked dividend, because of high LPG prices. Other stocks that will be affected by the fourth oil shock come in two categories: those that are hurt, and those that keep safely out of the way.

In the first category are the airlines and stocks that have anything to do with transport, such as Patrick Corporation and Toll Holdings, because of the cost of fuel.

The biggest cost for Qantas and Virgin Blue is fuel. But it could be the market has over-reacted to this since both have an additional fuel levy attached to their ticket price.

The other category are the so-called defensive stocks like the banks and Telstra. These have nothing to do with oil, which is their advantage. That's because they don't have anything to do with anything really, making them good all-rounders.

In any market shake-out, inevitable once Wall Street realises we're in a fourth oil shock, these are the stocks that will hold up.